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CORPORATE FINANCE IN EMERGING ECONOMIES

Finances according to Warren Edward Buffett

CASE 2

Academic Year 2017-2018


Period 5
23 April 2018

Águeda Gambón Cerdá 2620129


Paula Verdú Añón 2618570
Paula Garcia Soley 2619595

Course coordinator: Dr. Tanja Artiga González


In this memo, we will be doing a critical assessment along with our personal opinion on the finances of the
great businessman Warren Edward Buffett. We will talk about his largest billionaire acquisition. We will
critique his investment philosophy, and we will stress the most important issues when investing. We have
focused on the case written by Robert F. Bruner of the Darden School of Business that he wrote in 2015
about Buffett.
Bruner's case centers Buffett's philosophy on 9 points that we will discuss individually. The first
element stress about how the economic reality differs from the accounting reality.
Economic reality takes into account intangible assets (i.e. reputation). Nowadays, the GAAP
doesn’t take into account these assets, it measures the results in terms of net profit, in contrast with
Economic reality that measures results in terms of a business where its ‘flows of cash’. Buffett thinks that
the economic reality is key to guide investment decisions. We agree with this element in Buffett’s
philosophy, as we consider intangible assets to be really valuable for the company and its future
performance, since for managing tangible assets, knowledge, experience, etc are necessaries and a source
of competitive advantage.
When Buffett assess an investment, he takes into account the cost of opportunity of the
investment, in other words, the next best alternative. As we can see in the case, he frames his choices as
‘’either/or’’ business decisions. For him, comparing an acquisition/investment with other returns in the
market/stock of other companies, was an important standard. When making a decision in different
scenarios in real life, it is always more efficient to compare the different alternatives and choose the one
that provides a higher value for you taking into account the opportunity cost. It is important to weigh the
expected return of an investment and compare them with other alternatives/investments and for this
reasons above we agree with this point of Buffett’s philosophy.
The third element stress the importance of the intrinsic value -important concept in Berkshire
Hathaway acquisition of PCP which we will focus on later-, it is really important to understand this
concept as the present value of future expected performance. In other words, we can say the discounted
value of the future cash flows of a company and it is used to evaluate whether an investments or businesses
is attractive or not. From our perspective, we agree with his point because in a company, the book value is
related with accounting (equity value of the company). But accounting is the past and we are focused on
value in the future (finance) and here is where intrinsic value (future output) deviates from book value
(past input). Therefore, book value doesn’t reflect economic reality, we need to use a combination of both
methods. It is necessary to use an expected rate of return to create value and avoid value destruction.
Next element is related to the first one. Here Buffett stresses about Measuring the business
performance by gain in intrinsic value rather than accounting profit. Here the key element is to maximize
firm’s average annual rate of gain in intrinsic business value by using a per-share basis. We are focused on
per-share progress. We consider that his reasoning when using this method is correct because a gain in
intrinsic value is market value added.
The fifth element clashes with traditional financial theory. The conventional thinking holds that
investors should get paid more if they are holding more risk. To determine intrinsic value of the company
it is necessary to determine the discounted rates by the risk of the cash flows valued. In the traditional
practices, it is used the CAPM model. On the contrary, Buffett uses the rate of return on the long-run (30
years) to avoid risk, as this is a risk-free rate. From his perspective ‘’Risk comes from not knowing what
you are doing’’. We disagree with the method that he uses because even if the businesses that he is
investing in have low risk, all investments have a degree of risk and the rate of return has to reflect this.
Moreover, risk and profitability are related concepts, this doesn’t mean that a risky investment is always
the best decision but it is easier to take risk when you have information and a good analysis. From our
perspective the statement should be: ‘’If you know what you are doing, take risk’’.
Traditionally diverging the investment is something totally positive. Nonetheless, under Warren's
point of view, the widespread idea of diversification is an escape from ignorance. Priority should be given
to good knowledge of the industry and more investment in the face of greater diversification.From our
point of view, we consider that the reasoning that he is giving in this point is not enough and besides this,
we consider that in a lot of cases, he is using diversification across different industries when investing in
subsidiaries. Indeed knowledge about the industry is essential. However, no matter how good an
investment is, the markets always suffer shocks and the economies suffer from decreasing cycles.
Therefore, diversification is always beneficial against risk.
We agree with point number 7 of his philosophy, as It is necessary to always take into account the
long-term value and expectations of the company and not get carried away by emotions or short-term
shocks. The present information must be the first guide.
The eighth element of this entrepreneur's philosophy differs from the traditional theory of finance.
Buffett believes in the potential of businesses that have not yet become efficient. Instead of investing in a
publicized efficient business, investing in an inefficient one that promises can be more beneficial.
Conversely, the old financial studies explain how to invest in efficient businesses.
Our personal opinion agrees to invest in an unsuccessful business, as long as once investigated and studied
its potential is seen. Although investing in successful companies has lower risk, the benefit is lower.
Finally, Buffet focuses on the different interests of entrepreneurs and investors. It is necessary to
have both points of view when investing and running a business. We agree that a firm’s management and
shareholders should have the same goals for the firm. There has to be always a middle point where interest
of agents and owners agree, so that managers don’t try to act for their own benefit and follow the main
goal of the company: value creation.

Berkshire Hathaway is the name of the investment firm of Warren Buffett. BH did the largest
acquisition made by the “Oracle of Omaha” with a billionaire acquisition of the Precision Castparts
Corporation.
In the next part of our analysis, we are going to estimate the value of PCP firm using WACC
method, that is also the way to calculate the intrinsic value of the firm according to Buffett’s philosophy.
To calculate the intrinsic value of the firm we need to know the expected FCF and discount them to our
base year (2015) using the growth rate. The process we followed to calculate the expected FCF is shown in
Exhibit 1. As a result, we have a FCF (2015) of 2,093 million. We used the growth rate that is provided in
the case (2.5%) to estimate the expected FCF (2,145.33 million).
Next, in order to discount the expected FCF, we need to calculate the weighted average cost of
capital (WACC), that is a calculation of a firm's cost of capital in which each category of capital is
proportionately weighted. To calculate WACC, multiply the cost of each capital component by its
proportional weight and take the sum of the results (Formula in Exhibit 2):
rwacc = (0,831 X 0,092) + (0.169 X 0.023) (1 - 0.31) = 0,078823
rwacc= 7,88%
The value of the project (intrinsic value) is calculated as the present value of its future free cash
flows taking into account the indefinitely growth of PCP’s cash flows of 2,5%. Using rwacc 7,88% we
obtain: Intrinsic Value= 39.875 billion (Formula Exhibit 3).

The value of the bid for Precision Castparts Corporation was $32.7 billion without including the
outstanding debt. This quantity is the bid value, the cost of the investment and therefore the book value of
the company. This quantity reflects the value of the investment in accountability, but doesn’t reflect the
future value that company is going to create, to do so we need to discount the FCF, in other words use the
intrinsic value of the company that is calculated above: $39.875 billion.
In conclusion comparing the intrinsic value with the book value of the acquisition we see that
every dollar invested buys securities worth $1,234. Therefore, value is created, so Berkshire Hathaway’s
shareholders should endorse the acquisition.
Exhibit 1:

PCP Consolidated Financial Statements

Exhibit 2:

Formula WACC:

Exhibit 3:

Formula Firm’s value:


References:

- Investospedia Staff (2018) Warren Buffett: How He Does It. Retrieved from:
https://www.investopedia.com/articles/01/071801.asp

- El financiero (2015) Warren Buffett compra firma aeroespacial por 37 mil 200 mdd. Grupo
Multimedia Lauman. Retrieved from
- http://www.elfinanciero.com.mx/empresas/warren-buffett-compra-firma-aeroespacial-por-37-mil-200-
mdd.html

- Huky, G. (2015) Analizando la compra de Precision Castparts realizada por Warren Buffett. Retrieved
from https://www.gurusblog.com/archives/warren-buffet-precision-castparts-analisis/10/08/2015/

- Buffet, W. (2017) Warren E. Buffet, 2015. University of Virginia. Darden Business Publishing.

- Tanja Artiga González (2018). Advanced Valuation I [pdf]. Retrieved from URL
https://canvas.vu.nl/courses/29928/files/629049?module_item_id=108926